3 February 2012
Academic year 2011/2012
Academic and Study Skills
Semester 1, period 3
Evaluation among insurance companies on the decisiveness of diversification’s role in spreading investment risk Olaf Marangone
At the latest when markets began tumbling, financial dependencies became a global issue and whole countries’ economies ran the risk of falling apart, the curent crisis gave reason for questioning current investment strategies and even whole economic systems. Beside the banking sector which had to suffer a tremendous loss of trust also insurance companies were mainly affected by the crisis. Considering the credit crisis’ impact on global economy the central research question elaborates on the extent to what diversification of asset investments is a solid risk managing strategy. To determine the character of this strategy a closer view on the relative importance of diversification in the field of risk management has been taken. Besides diversification of asset investments the assessment criteria will be based on two other highly relevant concepts of risk management namely the consideration of non–linear dependencies during extreme events and handling liquidity risk. Because investment models of pension funds follow generally a similar pattern than these of insurance companies, an in-depth view on Denmark’s ATP Pension fund’s investment structure has been taken as an example for a successfully implemented investment strategy. The three mentioned sources will be used for section II, which will build up a theoretical framework around the issue being raised in the central research question. In section III, after assessing all three criteria of evaluation they should be used as a measurement for the role of diversification in the field of risk management. On the extent diversification in asset investments plays a role in the context of other risk managing strategies an evaluation will be made on in Section IV. Section V will contain the conclusion concerning the central research question.
Before answering the research question there are three elements that should be made clear; first of all the relation between investing in assets and the involved risk. Secondly, this section contains an introduction of what risk management is about. And finally it will be described what role diversification plays in the field of risk management. According to Pyndick & Rubinfeld, situations of investment decisions always involve tradeoffs between the monetary gain that could be expected and the riskiness of that gain (2009, p. 159). By nature, especially insurance companies and pension funds tend to spread their asset investments in a much more conservative way than for example banks did in the past. This behavior can be called risk averse and was in the case of Denmark’s ATP pension fund for the first time effectively developed after the financial crisis in 2001 (Rohde & Dengsøe, 2010, p. 22). Information regarding this particular fund was extracted from Rohde & Dengsøe’s article, which revealed instructive details necessary for a exemplary development of applied risk management. According to that, the creation of guidelines for risk tolerances of funds should ensure a strategy of long-term investment at a low risk level (Rohde & Dengsøe, 2010, p. 23). Two main goals were to be pursued. On one hand ATP’s reserves should be protected against extreme market fluctuations, and on the other hand returns should be created in order to cover the purchasing power of pensions (Rohde & Dengsøe, 2010, p. 24). Therefore, ATP divided its investment assets into two different independent portfolios. By allocating their resources to a variety of activities, Denmark’s ATP fund managers did nothing else than reducing their risk through diversification. In being more specific regarding the central research question, asset investments can also be themselves diversificated in a...
Bibliography: Eling, M., & Schmeiser, H. (2010). Insurance and the Credit Crisis: Impact and Ten Consequences for Risk Management and Supervision. The Geneva Papers, 35, 9-34.
Lehmann, A. P., & Hofmann, D. M. (2010). Lessons Learned from the Financial Crisis for Risk Management: Contrasting Developments in Insurance and Banking. The Geneva Papers, 35, 9-34.
Pindyck, R. S., & Rubinfeld, D. L. (2009). Microeconomics. New Jersey, NJ: Pearson Prentice Hall. 159-191.
Rohde, L., & Dengsøe, C. (2010). Higher Pensions and Less Risk: Innovation at Denmark’s ATP Pension Plan. Rotman International Journal of Pension Management, 3(2), 22-30.
Wagner, W. (2010). Diversification at financial institutions and systemic crisis. Journal of Financial Intermediation, 19, 373-386.
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